Papa John's International Inc (PZZA) 2004 Q2 法說會逐字稿

Good morning. My name is Marcus and I will be your conference facilitator today. At this time I would like to welcome everyone to the Papa John's International second quarter 2004 earnings conference call. All lines have been placed on mute to prevent any backgrounds noise. After the speakers' remarks there will be a question and answer period. If would you like to ask a question during this time simply press star then the number 1 on your telephone key pad. If you would like to withdraw your question press the pound key. I would now like to turn the conference over to Mr. David Flanery, Chief Financial Officer. Sir, you may begin.

Thank you, Marcus. Good morning. With me on the call today are John Schnatter, our Founder and CEO, Bill Van Epps, our Chief Operations Officer and other members of our executive management team. After a brief quarter and year to date financial update Bill will provide an operations and marketing update followed by some closing remarks from John. The management team will then be available for Q&A. Our discussion today will contain forward-looking statements that involve risks and uncertainties relating to future events.

Actual events may differ materially from the projections discussed today. The call is being taped and the replay will be available for a limited time on our website. Revenues were up slightly for the quarter and year to date in 2004 versus the same periods in the prior year as the second quarter consolidation in accordance with FIN 46 of the operating results of 4 franchise entities representing 33 restaurants added approximately $5 million of revenues to both current year periods. The favorable impact on higher cheese costs on 2004 revenues was essentially offset by the negative impact of reduced transactions at our Commissary business segment.

System-wide comparable sales decreased 1.9% for the quarter and .7% for the year to date with Company owned restaurants achieving slight comparable sales increases for the both periods. Ticket averages for both Company owned and franchise units have increased in 2004 in response to our strategic efforts to reduce discount levels through the use of the value added pizza entertainment promotional component of our marketing program. And in some cases increases in menu prices. However, this means that restaurant transactions lagged comparable sales decreases for the first half of the year leading to the reduction in Commissary transactions as noted above. This trend continued into July as the 3.3% comparable sales increases for the domestic system represented the impact of ticket average increases partially offset by transaction decreases.

Net unit growth continues to be challenging as the 41 domestic restaurant openings for the first 6 months of 2004 are below expectations for the year although they are ahead of 2003 levels. Unfortunately closings for the first half of the year are substantially higher than both prior year results and current year expectations, primarily as a result of the termination of a large franchisee in the Chicago market. Based on these first half results we have revised our full year guidance for both domestic openings and closings.

Margins for Company owned restaurants were comparable to prior year results for both the quarter and year to date period excluding the impact of the consolidation of BIBP, the cheese purchasing entity required to be consolidated in 2004 in accordance with the FIN 46 guidance. Slight increases in food costs, primarily as a result of higher cheese prices charged by BIBP and in other operating expenses, primarily as a result of higher insurance costs, were offset by labor reductions due to staffing efficiencies and leverage on the higher ticket averages due to the previously noted restaurant pricing increases.

Commissary and other margin was approximately 2% lower for the quarter and year to date in 2004 as compared to the prior year period, primarily as a result of higher cheese costs since cheese has a fixed dollar rather than a fixed percentage market up and higher sales of lower margin promotional products, basketballs in quarter 1 and DVDs in quarter 2. The unfavorable impact of these items was partially offset in Q2 by a decrease in claims loss reserves expense for the franchise insurance program. Although the $1.2 million incremental claims loss expense in 2004 was only about 1/2 of the 2003 expense and, therefore, favorable on a year over year basis, it was an unexpected reduction in our current year results. The additional reserves reflect both increases in general healthcare costs as well as our specific claims loss history for the program.

We believe that our current premium rates are sufficient to fund future claims losses at adequate levels although the actuarial predictability of ultimate claims costs continues to be subject to volatility and uncertainty. General and administrative expenses have increased $1.1 million for the quarter and $3 million for the year to date in 2004 as compared to the prior year. These increases were primarily due to the cost of stock options awarded in late 2003 that vest and are expensed over a 12 month period throughout 2004, increased bonuses for corporate and restaurant management who achieved specific performance goals and increased administrative costs related to supporting our international franchise growth.

The major components of other general expenses for both the quarter and year to date in 2004 and 2003 are discussed in the earnings release. Both recurring and non-recurring items are included in this caption and on a full year basis these costs are relatively comparable after considering the favorable impact of both the $550,000 gain on the sale of unused property included in the 2004 amount and the $2 million litigation settlement included in 2003, and the unfavorable impact of increased provisions for uncollectible accounts receivable in 2004. Net interest expense decreased in both the quarter and year to date periods in 2004 as compared to the prior year, primarily due to a $625,000 benefit recorded pursuant to a FASB statement 150 related to the second quarter change in a joint venture operating agreement to eliminate a mandatory purchase requirement and the related liability.

Additionally the average debt outstanding during the first 6 months of 2004 was lower than that outstanding during the same period in the prior year. We repurchased $26.2 million of Company stock during the second quarter and 50.7 million during the first 6 months of 2004 while receiving total proceeds of $10.3 million from the exercise of stock options during the first half of the year. Additionally, subsequent to second quarter we have repurchased $4.3 million of Company stock to date.

The Board has authorized share repurchases of 425 million and to date we have repurchased a total of 406.6 million. Our line of credit balance was $93.5 million at the end of second quarter and has increased to $98 million to date as a result of the additional share repurchase activity and the BIBP deficit funding. We will continue to consider share repurchases as an appropriate use for free cash flow and or increased leverage taking various economic and industry factors into consideration.

As previously discussed we were required to consolidate the operating results of BIBP Commodities beginning in 2004. BIBP is the franchisee owned entity conducting the cheese purchasing program for the Papa John's system. Second quarter 2004 pretax income was reduced $18.3 million, or 66 cents per share, and pretax income for the first half of 2004 was reduced $20 million, or 70 cents per share from the consolidation of BIBP. The consolidation of BIBP could also have a significant impact on operating income in future periods due to the volatility of cheese prices.

Based upon current milk futures prices we have projected that BIBP will increase the Company's operating income by $9 million during the next 4 quarters. We were also required to consolidate the operating results of 4 franchise entities representing 33 Papa John's restaurants beginning the second quarter of 2004. As expected the consolidation of these entities did not significantly impact Q2 results and we do not expect any significant impact in future periods. Finally, we are reaffirming our 2004 earnings guidance of 220 to 228 per share including an expected 8 cents per share benefit from the actual and anticipated repurchase of stock, although we have noted that the expected impact of unfavorable domestic unit count on franchise royalties and Commissary operating results make it more likely that earning will be near the lower end of the range.

We provided an updated schedule of significant assumption considered in deriving the reaffirmed guidance as an attachment to the earnings release. Now I will turn the call over to Bill Van Epps our Chief Operations Officer who will discuss our operational and marketing efforts in more detail. Bill.

Thanks, David. I would like to start by updating you on several initiatives we discussed during our February call. We mentioned a need to improve restaurant margins and while we've made substantial progress in reducing product costs through our procurement activities and limited specification changes not impacting product quality. As an example, the change to a brown box commodity increases have negated the impact of our positive efforts in this area and we are expected to continue at about normal levels for the remainder of 2004. However, we believe that negotiating savings leave us very well positioned for sustainable margin improvements once general commodity costs return to more normal ranges. We have a longer term cost reduction initiative in the production, warehousing and distribution areas of our Commissary operations that should begin providing system-wide savings during 2005. We also aggressively attacked our new unit costs and have identified equipment and leasehold savings in the 10% to 15% range that we believe will help support future unit development.

We have continued to improve our operational execution based on our ongoing efforts to monitor key performance indicators. We are very pleased with our project execution throughout the system and now believe our greatest opportunities for continued improvements are in the service aspects of our business. We recently began an initiative to identify opportunities to improve the effectiveness of our front line restaurant personnel in serving customers. For example, we found that currently not only do we not suggestively sell our customers consistently but in fact we often downsell the customer to a more deeply discounted deal than the customer might have expected. We expect this broad initiative may require changes in certain instore processes, better use of our technology resources and related revisions to our training, materials and programs. Accordingly, measurable results from this initiative are not expected until 2005.

Our domestic and international development pipelines continue to improve. We now have approximately 386 domestic and 714 international restaurants contractually committed to open throughout the next several years. Our success rate for these openings domestically will depend upon several factors. The most important of which will be the ability to demonstrate sustained positive sales trends and to realize the unit level margin improvements I've previously mentioned. In the next few years we expect the mix of new unit openings to shift more towards international as our domestic market penetration begins to approach saturation.

We are generally pleased with sales results for June and July. However, while driving ticket average and reducing discounts as we saw these recent results - - in these recent results, the overall objective of our marketing program is to achieve transaction growth. Or at least to stem the trend of decreasing transactions. This brings us to a brief review of these primary tactics supporting our marketing strategy. First we wanted to re-establish the worth of our signature 14-inch pizza by developing a value added pizza and entertainment program. The DVD program we rolled out in May appears to have been successful in accomplishing this objective as evidenced by our increasing ticket averages.

The system has also improved positive comparable sales in 9 of the most recent 11 weeks through the end of July under this program. Although as previously noted we have not yet seen transaction growth. We announced our second series of DVD titles in early July and they've been moving in accordance with our expectations. Beginning in September we will begin offering new titles each month through the end of the year. Next part of our marketing strategy was to add 12-inch products to target the value segment of the market.

We had previously been disadvantaged relative to our main competitors in this segment by having to fight their 12-inch deals with our 14-inch product and its related higher food cost. The 12-inch product has now been rolled out to a substantial portion of our system and we believe we will start seeing margin improvement benefits from adding it to our sales mix during the last half of this year. We are being particularly careful to include the 12-inch in bundled offers as much as possible in order to avoid the negative impact of ticket average trading down from 14 to 12-inch. Finally, a key in our overall strategy is the use of new product news to driver consumer interest and therefore drive transactions. We believe a major factor in the success of new product news to drive transactions is the ability to get our message out through an increased television advertising.

As we have previously discussed, our system voted to support our marketing program by increasing the level of contribution to the national marketing fund and, beginning in September, we will see sustained increased levels of national advertising through the end of the year in support of a series of new product offerings. Obviously for competitive reasons we won't discuss any more specifics of these promotions at this time. Although you might look for some changes in the creative from our most recent spots. We are working with an executive search firm to identify and retain a Chief Marketing Officer as quickly as possible. We believe we have begun many positive initiatives that a new CMO can build upon. But we also believe there are areas where new ideas and approaches can help us achieve greater successes in the marketplace.

And finally, we're very excited about our joint venture arrangement with Blue and Silver Ventures Limited, announced yesterday. We believe having operations and marketing partnerships with Jerry Jones and the Dallas Cowboys Organization will provide a significant boost for the 71 joint venture restaurants in Dallas, Austin and Waco, as well as many other franchise Papa John's restaurants in adjacent markets. Now, I would like to turn the call to our founder and CEO John Schnatter for some closing remarks before we open the call to questions. John.

Thanks Bill, really quickly. During the first 6 months of this year our management team has continued to be relentless and focused on 2 areas of our Company. First, improving restaurant level unit economics by driving out cost. And second improving product quality and service at our restaurants, we call that DV or demonstrative value. As to the cost side of our business our procurement team had implemented more than $30 million in savings of 40 million on annual run rate. This has happened while commodities have offset these savings. Nonetheless they are real and they'll continue to benefit our franchise community and corporate stores.

Our BIBP cheese purchasing program is working just as planned. For the first half this year the program has kept $20 million in cheese costs from the hitting our system at a time when the price of cheese is at an all time high. Thus reducing the volatility in the price to this critical commodity to our restaurant. And our Commissary operation has absorbed $2.5 to $3.5 million this year, by taking a lower margin on sales rather than raising prices to our system making the agreed upon 3% after tax margin we are not making the 3%. In our focus on restaurant mission criticals, again DV is also paying off.

Those operators consistently executing a quality product, getting it to the customer in a reasonable amount of time, are seeing health gains in comp sales, higher per store averages and more profitability. Unfortunately operators that are not executing the fundamentals, the block and tackling, are dragging down the system. Bill and John and Josh will talk more to that. And finally to Bills point we are extremely excited about the partnership with Dallas Cowboys; extremely quality operation in Texas. We've done dealings with Jerry Jones and their organization now for 3 years with the Desperados. And extremely excited to have the Cowboys partner with Papa Johns. And what better partner to have in Dallas, Texas, than the Cowboys. With that we will open it up we'd be happy to answer any questions. Thank you.

Marcus, if you can go ahead and open it up for questions, please.

Thank you. [Caller Instructions.] Your first question comes from Barry Stouffer, BB&T Capital Markets.

Morning gentleman. I had 2 questions, wondered if you could shed some color on your comment about transactions are down, pricing is up, just a little more specifics on how much menu price increases have been taken and exactly how much transaction counts are down?

Barry, this is David. We really don't give specifics on that. We just generally talk about trends and so what we said that it is true that while we have been successful in reducing the level of discounting as is our objective that unfortunately it hasn't yet driven the transactions. And you can probably get a little more flavor by seeing our Commissary results, too; where the largest factor impacting Commissary is obviously restaurant transactions.

Okay. And with respect to the savings and procurement, can you quantify that at all with respect to how that might show up on food costs next year? What type of basis point improvement you might see in Company food costs?

What we are seeing right now, Barry, is that the savings we've gotten so far are pretty much offset by the higher commodity cost the last half of the year, both cheese, chicken, meats, even wheat a little bit. All sorts of commodities are looking up the last half of the year, and we will probably later in the year give a better feel for what 2005 looks like. We haven't given any specifics of 2005 at this time.

Okay. Thank you.

Your next question comes from Mike Smith with Oppenheimer.

Good morning. A couple of questions. 1 of you said that you said you were scoring well on key performance indicators with your customers but I heard some kind of like troubles with some of the franchisees, could you tell me about those key performance indicators and maybe be a little bit more specific?

Yes. We concentrate on delivery time and the quality of our product. As well as 15 to 20 other measures that we track both for the franchisees and the Company operators. So we measure a lot of key performance indicators that are important to the consumer. While those have improved significantly we do io have pockets where performance hasn't met our expectations and as John mentioned, it really is basic blocking and tackling. Those who are doing a great job are seeing significant performance improvements in sales and profitability. And those that aren't, aren't.

Thanks. Another question, the TV advertising that you are going to start again in September, I guess, how much will that be up year over year?

Mike, it really various. And I think we have said that the increased level of contributions to the national fund are up substantially beginning in June of this year. So that will be up significantly. The key is when you're looking at the advertising overall some of the markets we are able to buy local advertising anyway so just shifting to it national doesn't really do much for some markets. Where it definitely help us is in the under penetrated and more struggling markets because they couldn't afford to buy national anyway. We've characterized this mainly as a shift in total advertising rather than an increase in total advertising dollars for the system. There might be a little bit of increase out there but it's mostly just a shift of type of advertising.

I guess my last question, BIBP has got a $20 million deficit I guess in it right now or thereabouts. And then according to the news release you start to get that back in the 4th quarter and then next year at about a 4 million plus rate per quarter. Is that an honor system or is that a - - is there a legal requirement for the franchisees to pay more than what cheese costs when you try to get that back?

The way that works, Mike, and we were very careful when we set that up and we also had certainly not only the encouragement but basically the direction from our Franchise Advisory Counsel to set the program up. So the franchisees are certainly on board with it. But basically the way the program works, if you elect to opt out at an point in time you can't opt back in. So there's really a penalty, if someone wanted to trying to go out and game the system and buy cheese at the spot, first of all I'm not sure that a group of 5 stores or 10 stores could go do that any way with our volume purchasing ability but let's say they tried, they couldn't really accomplish that. So we were very careful when we set the program up that all the stores are participating in it and will continue to participate in it.

Thanks.

Your next question comes from Tim Rice with Rice [Valker.]

Good morning. My first question is on the July comp. In the past you've usually quantified the impact from advertising programs on comp variances and I didn't see a comment this month. Can you give some guidance as to what the impact was from the advertising programs?

Tim, generally what we've tried to quantify in the past is when there's been a mis-timing of a holiday, Easter, New Year's and so on. We really are careful to not try to specifically quantify the impact of national. So I think what you've seen in our past releases are more quantification of holiday mismatches between periods and so on.

Okay. My second question is more of a strategic inquiry, I guess. It seems like, I guess because of industry fundamentals you pretty much abandoned a growth strategy. And to see a buyback continue with borrowed money in a period of deteriorating fundamentals is a little bit disquieting. Can you give some assurance that this is the best use of the Company's cash at this time?

Tim, the increase in our debt quite honestly a good good portion of that is related to the BIBP funding deficit and not directly borrowing to buy back stock. We will have $40, $45 million of free cash-flow during the year. So I think we would agree with you that perhaps increasing leverage at this time in the industry may not be the right thing to do to buy stock back. But use of our free cash-flow is certainly, we think that's a very viable way to increase long term shareholder value and the good news is, we haven't really abandoned a growth strategy. We certainly expect that we can get net unit growth going again. Bill mentioned the development pipeline is filling up well. It's much improved over a year ago. Now what we have to do is make sure that we have the good comp sales trends and the improving margins which we believe are coming that will get us the net unit growth, also. So that's, and, again, most of that growth is with our franchisees capital. We don't need our corporate capital. So again that free cash-flow we believe the best use for it at this point is reinvesting in the Company's stock.

Okay. And 1 last question on the Dallas Cowboys deal. I real realize that terms were not disclosed but it appears at least from the surface in reading the release that you traded a 49% interest in those 71 units for the right to be the official pizza of the Dallas Cowboys and to have the stadium sponsorship. Is that a fair characterization of the deal or did you actually receive some cash?

No, there was actually a purchase and sale involved. We are just not going to release specific terms. But it was not merely an ownership interest in exchange for sponsorship. The Cowboys have actually joined us and then put their capital at risk to win in the Dallas market.

And if I understand correctly these were 71 stores that were previously Company owned stores in total, is that correct, or was there a franchisee involved?

No, these specific stores were 100% Company owned.

Great. Thanks very much.

Thank you, Tim.

Your next question comes from Jeff Putterman with William D. Witter.

Hi, I have a couple of questions. First, just so I understand the development pipeline because I agree with the last caller that if you can't grow the number of stores then we have a problem here. You say that you have to get the comps up but these people are contractually obligated. Are you concerned that the current franchisees are closing stores faster than the new ones are opening it? Or can the new ones walk away if the comps don't start growing?

We have over 300 commitments for future development on the domestic side, contractual commitments for unit openings. So we don't believe that those agreements will be terminated. On the international side we have over 700 commitments for future development. And we don't think that those are at risk, either. But we understand the need to drive the economic fundamentals of our business so that we have an increased pool of domestic and international openings for the future. So we are focused on improving the fundamentals not only to insure that the commitments that we already have opened but to drive future commitments as well.

This is John Schnatter, to piggyback on what Bill is saying, this is a 3 prong process and the fundamentals 30 months ago were so bad that there just wasn't anything real solid to grab a hold of. This is no longer an IQ test. We can show that if you execute the concept correctly you can raise sales. And now the key is, once you raise sales, getting some of that money into the bottom line. So it's been a 30 month process. We've definitely sees a correlation between good fundamentals, good demonstrable value and good sales. And what's coming into focus very clearly is the winners, both corporate and franchise that do execute the business properly, made most of the money. Now we just need more winners. And we are spending a lot of the time using the winners as examples, rewarding the winners, having them spend time with the people that as we say "don't get it". And at the same time driving cost out of our business. So there's a little more lag than I would have liked. There was a little more lag going down than we probably deserved. But this is no longer an IQ test. Either you want to get in and make it work or you don't. And we have analytical data that's fact based that's nonnegotiable. And the people that want to step up to the plate, run their business with integrity, they are going to win. The people that don't, then we're going to have to replace them and get people that do want to win and do want to do it right.

Did you say earlier that the restaurants that are performing properly, the revenues are increasing but the customer counts are staying static?

Yes, I think that's fair that we are still looking to drive transactions which is as Bill mentioned we think with our marketing program that kind of all sinks up in September and forward we'll have a much better opportunity to do that.

Okay, and then with the DVD promotion, do you actually make more absolute dollars and percent margin dollars on the sale of a pizza with a DVD or the sale of the pizza without the DVD?

We make more with a sale with a DVD because we are lessening our discount by offering this value added premium instead of the average discount that we had given before.

But do you make money on the DVD by itself or do you lose money on the DVD to get the pizza price up?

Honestly it kind of depends on how you want to look at it. In the past we may have had a $10.99 2 top pizza. And now we are doing a $14.99 pizza and giving them a DVD that costs a little over $1. So we consider that bundle obviously producing 2 extra dollars of contribution margin, 3 or 3 extra dollars of contribution margin. So that's what we are actually looking at.

Okay, and is it fair going back to the buy back to say that you don't have a better use of capital to develop new products, to help the franchisees, to help your own restaurants, to put the money back into marketing, to compete better than buying your own stock back?

We are actually doing both. We are investing heavily to support the system in terms of new product development initiatives to lower the operating cost of the restaurants, particularly in food cost and some other semi-variable operating costs. So we are doing both. We have to do both at the same time or we intend to do both at the same time.

Okay. I'm not sure I get the buy back but thank you.

Thanks.

[Caller instructions.] You now have a follow-up question from Mike Smith with Oppenheimer.

Is your marketing in the second half of the year or towards the ends of the year here, did I hear correctly that you are going to introduce new movies every month as well as you are going to be promoting some new products at the same time or was that a combination of 2 things?

No, no, you heard correctly. We are doing both.

Is that not a more aggressive stance than you have taken in the past with marketing?

Yes, it is, and the reason we are able to do that in the last half of the year is because the change in the production fund vote and we will be able to buy TV more frequently in the second half of the year.

And the production fund is now, what, 3% of sales?

It's a little over that, Mike, just slightly over that.

And, David, how would you characterize the pricing in the industry now vis-a-vis your competitors? What are they doing?

I'll start and let Bill jump in, too, but earlier through the Spring, probably early Summer I think we were very encouraged as we saw kind of across the board some lessening of discounting and so on within the industry. And now obviously recently we've seen the Domino's, the 555 deal which we are obviously watching it very carefully to see if the reduced discounting will stay in effect. We certainly hope it will. We think that's good for the whole segment. I will let may Bill comment on it, too.

When cheese prices were high we saw shelling out of discounting and we have recently seen a re-emphasis of some discounting.

Thank you.

Your next question comes from Tobin Kim with Silver Capital.

Good morning. Just a quick point of clarification, I wasn't sure if the additional 22.5 million of repurchase was in your previous guidance?

No, our earlier guidance did not specifically assume share repurchase, that is correct. That's why this time we specifically say we are including 8 cents of accretion from share repurchase, that is correct.

Okay. Thank you very much. I appreciate it.

Yes.

Your next question follow-up question comes from Jeff Putterman with William D. Witter.

Let me follow up on that one, first. So, in other words, X this incremental kick from the buyback you would have been guiding down all other things being equal?

That's correct.

Okay. Thank you.

Your next question comes from Frank Bird with [Hawkshaw].

Good morning. Could you quantify over the next 12 months ballpark how many new products do you plan to be promoting and how would that compare to say the last 12 months? Thank you.

We really don't comment for competitive reasons on the details of our marketing plan. I just can't do that.

I think what we have said, Frank is that you can expect it will be a greater number but we are going to stay out of specifics.

Gotcha.

Your next question comes from Jeff Putterman with William D. Witter.

Sorry, I was trying to give somebody else a chance. This is my last question. A lot of other companies that are selling wheat based products like your pizza dough are complaining about Atkins affecting their sales. Is that affecting your sales or is that something you don't see at all?

It's really hard to determine what effect the Atkins trend is having on the business. We think that pizza is an indulgent item. And not quite as susceptible to the dietary trends some refer to it as a potential fad, as bread or some of the other main wheat items. So we think it may have had a little bit of an impact but we are staying our course.

Thank you.

At this time there are no further questions. You may proceed with the presentation or any closing remarks.

No, that's it, Marcus. Thanks everyone, good by.

This concludes today's Pap Papa John's International second quarter 2004 earnings conference call. you may now disconnect